Industrial Report: One foot in each world

Bigger is better, flexible is more popular, and speculative development is still on the upswing. After two torrid years, the dot-com fever finally has broken. The love affair between industrial developers and telecom companies appears to be over, and industrial impresarios from all over are facing a more traditional market compared to the heady activity of 1999 and 2000.

In short, it's back to the basics for the nation's industrial real estate sector. As the U.S. economy slows, the rapid expansion of numerous companies has cooled, and an increasing number of former high-flying firms have bitten the dust.

“We've become more cautious, like everyone else,” said Greg Gregory, president and CEO of Atlanta-based IDI. “We've got one foot on the accelerator and the other on the brake. The Old Economy business continues to be favorable with all the good, solid users still there, and we're even leasing at a steady pace. But the high-tech world has changed.”

According to Kelly Landwermeyer, regional director of industrial properties at Houston-based Weingarten Realty Investors, industrial developers throughout the country have become more cautious as they face rising vacancy rates and a less robust economy.

Landwermeyer added that Weingarten is taking a wait-and-see attitude concerning industrial projects. “The riskiest play a REIT can make in times of economic uncertainty is spec industrial development,” he said. “We want to monitor the economy for the next six months and see where it's headed to determine if new industrial projects are needed.”

Space-user trends

Landwermeyer noted that there is a dichotomy in industrial development in the Houston area, as in other sectors of the country. Some developers think “bigger is better” and seek to serve one user, while others are continuing to build smaller office/service centers to appeal to a variety of clients.

Bill Linville, executive vice president of the Midwest industrial division for Indianapolis-based Duke-Weeks Realty Corp., said that size and location are certainly playing a major role in industrial development in the country's midsection, and the two will probably continue to do so in the future.

“People used to think they needed to be close to a manufacturing plant, but now they don't because of logistical efficiencies,” he said. “Also, companies thought they could only manage a building of 350,000 sq. ft. to 400,000 sq. ft., but that changed. As a result, during the 1990s a lot of distribution centers got as large as 500,000 sq. ft.-plus.”

Now, industrial projects of 750,000 sq. ft. to 1 million sq. ft. are not unusual, and the challenge for developers is to anticipate needs down the road. “In the future, these buildings might have to be split up for tenants that take 150,000 sq. ft. or 250,000 sq. ft.,” Linville said. “As a result, we want to make sure such large structures are designed so that they can be split up, if the need arises.”

One emerging trend, Linville noted, is that a number of companies want to own their own facilities. “A couple of years ago, the trend was that companies wanted to lease,” Linville said. “But now we're seeing more and more companies say, ‘If we're going to build, we think we'd like to own it.’ Interest rates are low and a lot of companies believe it is cost-efficient to go ahead and own their building.”

Thomas M. Boyle, vice president of Skokie, Ill.-based The Alter Group, agreed that industrial projects are getting bigger and noted that locations of facilities are also changing, with companies wanting to move closer to the labor pool.

“The market is driven by logistics companies, and expandability has been critical to logistics users,” Boyle said. “We're seeing the trend of 300,000 sq. ft. to 350,000 sq. ft. buildings under construction with the option that their size could be doubled, if the company needs the space. Companies are also moving closer to downtown, where more full-scale demolition is occurring, especially near downtown Chicago.”

Boyle added that in the past couple of months, the groundwork has been laid for sizable industrial developments closer to the central business district. Employers say they need to be in the greater Chicago market. The industrial work force is in the city, which is where companies want to be located.

However, industrial users don't want to wait for space. “In Chicago, the biggest driving force among industrial users is how soon they can get into the space,” Boyle said. “They don't have two years to wait for a brownfield development. If the space is ready, they will take it.”

Oversupply of space?

Another important trend in the industrial marketplace today is the slowing of leasing and building activity, according to James L. Dieter, executive managing director of the U.S. industrial group for New York-based Insignia/ESG. Dieter is based in Chicago.

“It's still business as usual, but what has happened in the last couple of months is that the telecom business has slowed and that is causing some concern,” Dieter said. “There was a flurry of activity in 2000 as developers acquired industrial sites. In some cases, industrial facilities were functionally obsolete and converted to telecom-type operations.”

Many of these developers received financing for projects based on the high rents telecom users were willing to pay. Dieter noted that owners that at one time leased space for $4 per sq. ft. were able to sign tenants in 2000 that were paying three, four or five times that amount — much higher rent than a building in a typical industrial space. But, if the tenants leave, will the developer be able to fill the buildings with high rent-paying tenants?

As a result, there is some concern in the industrial sector about the fallout from the recent e-commerce boom that crashed. For example, Foster, Calif.-based Webvan and the now defunct eToys leased large distribution spaces and have since vacated those buildings, or never taken occupancy.

Well-known companies such as Atlanta-based Home Depot and Bentonville, Ark.-based Wal-Mart have absorbed large distribution space for their dot-com businesses and are still doing fine. Dieter noted that it is the start-up, purely dot-com companies that are now vacating facilities.

“We're beginning to see large distribution buildings around the country now put up for sublease,” he said. “In 2000, we started to see the industrial subleasing business become very active. Some companies that leased industrial spaces didn't need the space anymore and have been trying to sublease. Also, with a softening of the marketplace, there could be more downsizing, with companies moving out of larger facilities into smaller ones.”

Peter McWilliams, senior vice president and manager for the Ontario, Calif., office of Los Angeles-based Colliers Seeley International Inc., cited space consolidation as another industry trend, particularly in California's Inland Empire, which has become the premier Western hub for distribution.

McWilliams said firms are consolidating three or four warehouses into one large one. As a result, several companies in the Ontario, Calif., market have secured spaces in excess of 600,000 sq. ft. during the past year. Among those companies are: Target Corp. of Minneapolis; Home Shopping Network of St. Petersburg, Fla.; International Paper of Purchase, N.Y.; as well as Home Depot and Wal-Mart.

Developers in the Inland Empire have built 10 speculative buildings, ranging from 600,000 sq. ft. to 900,000 sq. ft. during the past two years. Eight of those buildings were preleased during construction to meet this demand.

“There is more parking space for trailers in these new warehouses as well,” McWilliams said. “Basically, the length of the truck courts has grown from 110 ft. to 190 ft., so that a warehouse/distribution tenant can store more trailers adjacent to the facility in a secure yard.”

“Traditionally, the smaller truck courts could handle the 40- to 48-ft. trailers, but now 53-ft. trailers are common. Ideally, they should have 135 ft. to turn efficiently and up to 55 ft. to store additional trailers,” McWilliams added.

Size really matters

The “bigger is better” building philosophy has spread across the continent. In northwest Houston, for instance, Weingarten's Landwermeyer pointed out that a development group is building a project that includes more than 700,000 sq. ft. of speculative space.

“The theory behind [the group's] development is that Houston needs larger spaces than what has been built the past couple of years,” Landwermeyer said. “The thinking is that Houston is missing out on the regional distribution deals that flow to Dallas because Dallas has larger spaces available. They're building the space because they believe Houston doesn't have the space that will accommodate regional distributors. They are thinking, ‘If you build it, they will come.’”

On the other hand, several developers are building industrial space designed for smaller tenants in Houston's active northwest sector. “We'll have to wait and see what happens,” Landwermeyer said. “If it is successful, we'll see people follow in their footsteps and build industrial product, which varies from the standard that was established the past several years.”

Core markets are all the rage

There also is a trend in the location of industrial developments. Randy Baird, senior director at the Dallas office of New York-based Cushman & Wakefield, said institutional investors are now focusing on core industrial markets such as Chicago, northern New Jersey, Atlanta, Dallas and California. “We are seeing a very narrow focus on Class-A properties within those core markets. There also is an emphasis on the right submarkets in those areas.”

Baird noted that there has been a flight to quality in the industrial market. “The reason there is such a [price] spread between Class-A and B properties is that there are not as many Class-A properties left, and there is very little institutional interest in Class-B or secondary markets. Almost 80% of the offerings that have come out the past 12 months have been in secondary markets that were Class-B properties.”

According to Baird, the problem is that if an owner sells Class-A industrial projects, it is difficult to find similar property to redeploy capital. “There just isn't that much of the product on the market. Also, industrial is still in favor in asset allocation, so owners of that product are tending to hold on to it.” Baird added that it's going to be difficult for industrial investors to meet their acquisition expectations or to increase their industrial holdings to the desired levels if they continue to have such a narrow focus. “Widening that focus could improve the market for the better Class-B properties and for better secondary cities or secondary markets,” he said

John Bancherom, senior partner at Sacramento, Calif.-based Panatonni Development, agreed that many large industrial users want to be in the major markets, such as Los Angeles, Dallas, Chicago, the New Jersey-New York area and Atlanta.

“In Chicago, the single-biggest driving force among industrial users is how soon they can get in the space. They don't have two years to wait…” — Thomas M. Boyle The Alter Group

Bancherom predicts companies will continue to consolidate their space needs into fewer, but larger facilities. “By reducing 30 facilities to 10, a company can save on personnel, rent and facilities maintenance and management,” Bancherom said. “Management can focus on fewer facilities. For example, we recently completed a 640,000 sq. ft. building for [Palo Alto, Calif.-based] Hewlett-Packard in Richmond, Va. The company consolidated five facilities into that one complex.”

Bancherom added that Panatonni is not encountering as many build-to-suit proposals. “We're seeing more spec space development — nearly 60% spec vs. 40% build-to-suit. Users say they need product right away. Recently, Technicolor [based in Camarillo, Calif.] approached us about a 600,000 sq. ft. project we had finished. The company took the space,” Bancherom said.

Companies are reducing inventories, which is also affecting the industrial market, according to W. Blake Baird, president of San Francisco-based AMB Properties.

“Storage is in a secular decline, and with that we have another simultaneous trend — the acceleration of movement of goods through the supply chain,” Baird said. “Goods are moving quickly, in smaller pieces, and with more time sensitivity. Those trends led us to conclude that we should focus on the ‘speed’ end of the industrial business — buildings that facilitate the rapid movement of goods.”

At the same time, companies such as AMB are now looking to develop and own real estate in large markets at in-fill locations — particularly areas that have limited supply of product. “If you go back to Economics 101, it's the intersection of supply and demand,” Baird explained. “You want to invest where there is a limited supply, and on the demand side you want to invest with users growing faster than the GNP (Gross National Product).”

Technology factor

Several industrial properties are now under development with state-of-the-art options. McWilliams of Colliers Seeley pointed out that a majority of new industrial spaces use modern sprinkler technology, allowing companies to store product at new heights.

For example, Early Suppression Fast Response (ESFR) sprinkler systems now allow for higher storage without requiring tenants to spend an additional $2 per sq. ft. for an in-rack sprinkler system. Whereas the rack-sprinkler system is installed directly into the rack units — and prone to malfunction and leakage caused by collisions with forklift trucks — the ESFR sprinkler systems are installed at the ceiling level.

According to McWilliams, the in-rack systems are not only expensive but also less flexible. The majority of new warehouses may feature ceiling heights ranging from 32 ft. to 40 ft. and are equipped with ESFR sprinkler heads.

“The major difference is the old sprinkler systems were designed to suppress the fire until the fire department got there,” McWilliams explained. “The new system is designed to put it out with a deluge of water. If the system works properly, the fire never spreads, so additional sprinkler heads never go off, limiting severe fire damage, as well as water damage to the inventory.”

Tenants that install the ESFR sprinkler system may also realize savings on their insurance premiums, depending on the product they are storing and how high they are storing it, McWilliams said. He added that the industrial sector will continue to undergo technology upgrades as companies to demand more storage efficiency and safeguards to protect their inventories.

What it all means

Despite some common themes emerging on the industrial front, Gregory of IDI advises against making sweeping generalizations about American business. “It's very innovative, so it's always changing, and we spend a lot of time trying to understand what our customers are trying to do,” Gregory said.

“It's difficult to project any kind of major trend too far into the future because companies and industries have different needs,” Gregory continued. “They're trying to be flexible inside the distribution facility, and they're careful not to over-automate, so that they can adjust to the different product needs and demand.”